Value Investing In Real Estate: The Strategy You Select Determines How Fast And Easy You Earn Your Profits
BATTLECALL GUEST EXPERT: Robert J. Abalos, Esq.,
InvestingInLand.com
Value investing in real estate is very much like the Graham/Dodd style of
stock market investing made famous by Warren Buffett. Instead of finding
securities trading below their intrinsic (or economic) value, you find real
properties selling under their current cash value. In other words, after
discounting the cash flow value of a property to a specific rate determined by
an investor, you buy the real estate only if that value is higher than the
sale price.
Or as I put it before, you attempt to trade one dollar of cash for more than
one dollar in equity at the time of closing.
This sounds like elementary advice most investors already know but quite the
opposite is true. Most investors in both the stock and real estate markets focus
on MARKET PRICES, not intrinsic values. Market prices tell you what an asset is
currently selling for, or more precisely what the owner or seller of that asset
wants from a buyer to part with it. Market prices do not tell you
what an asset is really worth. That is the role of intrinsic value
analysis. The strategy of market price based investors is to "buy now, sell
higher" rather than the mantra of the value investor "buy low, sell later."
Value Investing Strategies
Every investor wants a bargain. No one wants to overpay for any asset but
unfortunately most do. That's why the vast majority of investors in any equity
asset class from real estate to the stock market lose money on their purchases.
The biggest mistake most investors make is not buying "bad" assets. Those
problems like poorly performing stocks or decaying rental properties are easy to
spot and avoid. Much more money is lost buying "good" assets but just paying too
high a price for them.
It is the value investing strategy you select before making any
purchase that determines your success as an investor. The goal is
not just to find a bargain, it is to find a bargain at the right price and terms
so you can realize a quick and easy profit.
Here are some common value investing strategies:
- Buying below market value
- Buying distressed assets
- Buying "hard" rehabs
- Buying "soft" rehabs
- Buying market mispricings
Only the last strategy, buying market mispricings, works all the time. The
others work occasionally but each involves a measure of risk not found in the
premier method of value investing.
Buying Below Market Value
Just because an asset is temporarily trading or selling below its normal
market value does not mean it is a bargain. Lots of stocks sell below their
100-day moving averages, higher than their average dividend yield, lower than
their average price/earnings ratio, or whatever other classic valuation method
is used and are still awful buys. The same is true of real properties. A home
that was once listed or sold for $200,000 may still be a terrible buy at
$180,000 or even $100,000.
The reason is market pricing. Market prices are set by market sentiment
disconnected from actual intrinsic or economic value. Selling a dollar for $1.30
and then cutting the price to $1.20 does not mean the buyer is getting a
bargain. This point is obvious when a dollar of cash is the example. It is
equally as true when a dollar of equity is involved.
On Wall Street market prices are said to float according to a "random walk"
theory, that is, unpredictably due to market sentiments. Benjamin Graham in his
classic book THE INTELLIGENT INVESTOR tells the story of poor old Mr. Market
whose mood swings between paranoia and fear and euphoria and excitement mean his
emotions dictate the prices at which he sells his equities, not mathematics or
statistics. When investors buy based on market prices, they enter Mr. Market's
psychological world where one day prices are driven higher by greed, the next
lower by suspicion. The bottom line is that it is impossible to predict market
sentiments because they are emotional, not scientific. They float like a moving
target on an ocean of news reports, events, rumors, and rise and fall with the
seasonal tides.
So buying a piece of land for 20% lower than its current market price or its
last sale price is no bargain if the actual intrinsic value of the land is 50%
lower.
Sometimes people get lucky. They buy on a dip when depressed market
sentiments drive prices lower and VOILA! Mr. Market gets giddy with glee and
market prices whipsaw higher.
But many times they do not. Buying at a discount to the current market price
does not look like a bargain when prices continue to fall. Look at the chart of
any stock and see how the line bounces along, up and down, in what is often a
very random pattern. The very same is true of real estate prices, although due
to the lack of liquidity you do not see regular bid/ask quotes on land lots or
apartment buildings. But real estate prices do rise and fall the same way, even
more so on occasion due to local conditions which are not normally factored into
national or international markets.
Do not buy equities of any kind based on market prices.
It is a dangerous and risky strategy that takes the money of most
investors that try it.
Buying Property from Distressed Owners
Another value investing strategy is buying assets from distressed owners such
as those facing foreclosure, a sheriff's sale, a tax sale, or some other forced
sale situation.
This approach to investing only works if the distressed owner is willing to
sell their property below its intrinsic value.
Often times, they are. Many times they do not. Again, getting a discount off
a market price is not the measure of success. It is buying that asset below its
real intrinsic value.
Distressed owners certainly are willing to offer discounts for cash or quick
closings or other incentives to get out of their trouble fast. This leads to
lower prices for sure. But buying at lower prices again does not mean the buyer
is getting a good deal, just a better one than buying at a higher price. I've
seen many foreclosure properties still sell for far more than they are actually
worth. Of course buying a dollar of real estate for $1.20 is better than buying
the same dollar for $1.60 but is it really a bargain at the lower price?
The strategy of buying properties from distressed owners is a sound value
investing approach but it is in the application of it where most investors fail.
They focus on the bargain they are getting and not the value they are
receiving.
Buying Properties that Need Hard Rehabs
The hard rehabbing of properties is your classic fixer-upper approach of
buying a house in need of repair, modernization, or improvement and doing the
work to add value. Everything from adding a room, finishing an attic or
basement, updating the kitchens and bathrooms, and more are included in this
strategy. Many, many books and courses advocate this approach to real estate
investing due to the fact that old, obsolete, and decrepit properties sell for
less than new, modern, and clean ones. With land investing the same technique is
to buy land, subdivide it, put in roads and utilities, and otherwise make the
land more valuable with physical and legal improvements.
This investing strategy has clear merit and does work but it has three
inherent problems. First, it is time intensive. It can take weeks, even months,
to repair and modernize a property and all the while there are likely
substantial carrying costs like monthly mortgage payments on a vacant home,
apartment unit, or parcel of land. Second, it is capital intensive. Buying a
$100,000 home for $40,000 is a great value investing play only if you have the
$40,000 to fix it up so this purchase can fairly compete against newer and more
modern homes on the market. Rehabbing a property costs lots of money and the
rule is that it always costs more than you think. Think over budget more than
under budget. Anyone who has ever attempted a real estate rehab knows the
problems here.
But the real weakness of this approach is that it is more of an operational
business than an investing alternative. A real estate rehabber really is in the
fixing up real estate business more than just owning and profiting from a real
estate investment. Think of the difference this way. Would you rather own a
restaurant or work in one? Would you rather show up every Friday night and take
your cut of the weekly profits or labor there every day, ten hours a day,
washing dishes, cooking food, and taking orders from customers to earn the very
same gains? As a real estate investor, I want my money working for me. I don't
want to work for it. Real estate rehab means running an informal construction
business where there are a hundred jobs to do, everything from soliciting bids
to cleaning up job sites to demolishing walls to selecting the color of bathroom
tiles. Some people enjoy this kind of work. They like to get dirty and work with
their hands. These individuals are good at it and especially have the home
improvement and design skills necessary to be a great rehabber. I just don't and
most people are just like me. I've done more than fifty rehabs and find the
process tiresome, filthy, occasionally dangerous, always stressful as you fight
the clock, and most of all really really boring. That's why I discovered land
investing. There are no houses or buildings to rehab and land can be sold raw
for quick profits.
Nevertheless, buying properties for hard rehabs is a profitable strategy when
the purchase price for them is low enough that the improvement capital deployed
on the project earns a sufficient return to make the entire venture worthwhile.
But there again comes the problem. Most investors do not buy these properties at
low enough prices or spend too much money or time rehabbing them to make the
entire ordeal profitable. Buying a home worth $100,000 all fixed up for $60,000
and putting $30,000 into the rehab makes no sense if you work for twenty weeks
like a dog to make $10,000 under the best of circumstances.
Still, every real estate investor at some point does hard rehabs and I
certainly recommend the strategy when the right property comes along at the
right price. But there is much risk involved so investors must use caution. This
is a dangerous value investing approach when things go wrong and from experience
I know they often do.
Buying Properties that Need Soft Rehabs
A soft rehab is merely a "paper" rehab or a change or improvement in a
property that does not require physical work. Classic examples of soft rehabs
are raising rents on a new rental property purchase because they are too low or
charging for amenities like parking spots or storage units when they were
previously supplied for free.
As a rental property owner and investor, I am always looking for soft rehab
projects, times where mere changes in management will yield immediate higher
profits. The logic here is very simple. Using a common cap rate of ten, every
$1.00 per month in additional net income on a rental unit translates into $120
in higher property valuations. So finding $100 per unit per month on a
twenty-unit building is the equivalent of doing a $240,000 hard money rehab
without tearing down walls, hiring contractors, getting building permits, or
spending a dime in improvement capital.
How do you do a soft rehab? You raise rents, boost net income, and cut
expenses. In other words, you make the rental property more efficient without
spending money doing it. Since you are not burning capital to make these
improvements the gains are free, meaning the yield on such additional income is
astronomical. That is why soft rehabs are so profitable and the preferred method
of investing.
Yes, soft rehabs often do take time, just like their hard money counterparts.
But they sure take less effort. There are many poorly managed rental properties
out there, I see them all the time. An investor may be an excellent dentist or
insurance salesman but that does not mean they will be an effective rental
property manager. Quite often these investors are well intentioned but just
plain incompetent or distracted by their full-time careers. They just do not
maximize profits because they do not take the time to figure out how. Even a
simple thing like charging tenants $50 a month extra for a parking spot rather
than including one in the base rent means each spot becomes an income stream. I
recently saw a ten-unit building where each tenant had a parking spot provided
for free but only four tenants had cars. The remaining six spots could have been
leased to tenants in neighboring buildings or used as paid outdoor storage by
tenants for additional income. That is ten spots x $50/month x 12 months x a cap
rate of ten or $60,000 in additional property value.
The bottom line is clear when value investing with rehabs. Both hard and soft
rehabs make money by building property income and subsequently net worth but
only soft ones come free, or very close to free.
Buying Market Mispricings
The simplest, easiest, and most risk-free way of investing is to merely buy
assets that are mispriced by the market. This is the single most important
approach.
Every investor with experience comes across market mispricings and other
errors with some regularity. They certainly are not common but they are not rare
either. I told you before of my first land purchase where I bought a rental
house that had an additional building lot attached. The owner and her sales
agent simply did not catch their error. Another common example is land that is
improperly zoned. In these cases the market price offered was a mistake. The
owner was selling something worth far more than the asking price. Put another
way, the intrinsic value of the purchase was greater than the sales price, or
more than a dollar of equity was being sold for just a dollar in cash.
The reason that buying market mispricings is so profitable is
that all the profit earned comes fast, easy, virtually risk free, and best of
all, for free. The investor who buys market mispricings is really
acting as an arbitrageur, finding assets where their real value can be realized
instantly just by passing the equity to a different market or buyer. If you buy
a dollar in cash for 95 cents, how fast can you sell that same dollar to someone
for 98 cents and make a profit? What is the risk in buying a dollar for 95
cents? Your profit is automatically locked in from the start. And what effort
does it take to sell dollar bills for 98 cents? No contractors, painting walls,
or landscaping projects and no capital outlays for the same.
Market mispricings do occur. Markets are merely the collective judgments of
many people about what an asset is worth and people, unlike God, are inherently
imperfect. Realize that I'm not speaking of situations that involved fraud or
deception, where the real value of an asset is obscured or inflated to benefit
someone. The market may have thought a share of Enron stock was worth $80 but
the insiders committing fraud knew the real value was zero. In that case the
mispricing was criminal and deliberate. What I am speaking of are situations
where legitimate asset values are misinterpreted or mischaracterized by the
market as a whole and the true intrinsic value of these assets not reflected in
the sales price. In the stock market, this quite often occurs with the shares of
company spinoffs and conglomerate stocks. Since these shares are hard to value,
the valuations attached to them are quite often wrong. With real estate quite
often an owner or seller is unaware of or misinterprets one of the variables
that determine a property's value. They do not know the correct zoning, or the
actual lot size, or know that their property is in the immediate path of
development. This explains why buying land from out-of-state owners works so
well for value investors. These absentee owners are detached by distance and
often time from their land and subsequently from the considerations that give
their property value so they often sell at prices below intrinsic value.
Other than the actual real estate examples of market mispricing I've
mentioned before, here are two from the stock market that I profited from
myself.
During the Internet heyday of 2000, 3Com decided to spinoff one of its most
profitable units, Palm, maker of the famous Palm Pilot. 3Com itself was a
successful computer networking company but it had been overshadowed by its Palm
success story so a spinoff was sought as a solution. The terms of the spinoff
were simple. For every share of 3Com an investor owned, they got 1.5 shares of
Palm. But soon after the IPO of Palm shares and before the spinoff to
investors Palm shares traded at nearly $100 per share. This would mean that
each 3Com share was worth at least $150 per share just in Palm shares alone. And
3Com itself was a profitable company itself with more than $750 million in
annual net income. But 3Com shares were themselves only selling for $80 at this
time. Market pessimism on the future of Palm had radically discounted the price
of the parent. But it did not take a genius to figure out that the intrinsic
value of 3Com plus Palm was more than the value of just 3Com alone.
Another example occurred in 1999 when the market capitalization of Keebler
Foods totaled $2.5 billion. Since 55% of Keebler was owned by Flowers
Industries, their ownership of Keebler was worth at least $1.38 billion. But at
the time the entire market cap of Flowers was only $1.36 billion. Flowers also
owned other assets worth at least $1 billion. Again, it doesn't take a rocket
scientist to realize that the intrinsic value of Flowers is much higher than
$1.36 billion (and its corresponding stock price) when it owns at least $2.38
billion in assets alone. This was a bargain purchase.
Let's be clear on one very important point here. The only time
you buy an equity that is mispriced by the market is when it is selling below
its intrinsic value. Market mispricings mean that the real value
of an asset is not reflected in the market price. Of course markets can misprice
assets higher than their real intrinsic value or just plain price them below
previous market prices. Do not think that searching for market mispricings means
you are buying on the basis of market prices. What you are looking for are
assets that can be had after calculating their intrinsic value and determining
that the current market price on them is in error, that there are hidden values
or other factors present that mean you can buy a dollar of equity for less than
one dollar in cash.
The Bottom Line on Value Investing in Real Estate
All the above value investing strategies work and can make an investor money.
The real issues are how quickly can you find a target property, how much time,
money, and labor do you need to make them work, and how fast can you realize
your profits.
I never buy equities of any kind on the basis of market prices or discounts
off market prices. That's a foolish and dangerous strategy and if there is one
lesson you can learn that's it. But I've used all the other strategies detailed
above and continue to use them on occasion. I've gutted old 1950s era homes and
buildings and modernized them, bought forced sale properties from owners, banks,
and even their creditors, plus done many soft rehabs for myself, partners, and
clients. But clearly the easiest and fastest way of making money is to find
situations where markets are just wrong and assets sell for less than they are
really worth. You have to search for them, no one puts a neon sign on a bargain
asset screaming "Buy a Dollar for 90 Cents, Here!" While such mispricings are
not rare they do indeed can be found all the time, in all markets, bull and
bear. Most times they occur because sellers or their agents do not know the real
value of their assets since they have not taken the time to evaluate all the
variables that make up that value or actually crunched the cash flow numbers
like a good value investing intrinsic buyer should. The whole focus is not
the creation of value in real estate but the discounted purchasing of it. Why
spend money, sweat, and time to create value when others will give you the same
value for free?
When you can find such a mispriced asset, buy it! If you buy a dollar for 90
cents on a Tuesday, how fast and easy would it be to sell the same dollar for 97
cents on a Wednesday?
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